The United States Declaration of Independence affirms the people’s right to “life, liberty and the pursuit of happiness”. But the pursuit of money is a far more obvious concern in most people’s lives. Money now, happiness later! Although the quest for money is perhaps the leading human preoccupation of modern times, very few of us truly know what it is, or understand the laws that govern it. And that’s not just ordinary people. Economic ignorance is almost a qualification for the highest office in governments, treasuries and central banks. To appreciate this, just listen to almost anything George Osborne has to say on the subject – as he blindly drives the UK economy into a continued and deepening recession.

Take one example: his insistence that because the UK economy is in recession, and tax revenues are consequently reduced, the government must cut its spending. This would of course be true if a government’s role in an economy was that of an individual, family or company. But there are important differences whose effect makes Osborne’s dictum not just wrong, but the very reverse of the truth. During recessions the role of government is precisely to increase spending – and especially on long-lived assets (of many kinds) that will contribute to future wellbeing, prosperity, efficiency and resilience.

This simple fact is of enormous importance. It means that all the suffering imposed on the UK, and on other countries stuck in the same obsolete policy framework, is unnecessary. It serves no useful purpose, but is rather the cause of huge falls in the standards of public service, for no corresponding benefit.

So, just how is it that governments are different from you and me? First and foremost, governments have the power to create money. This is something no one else can do – at least in the sense of running a £50 note off a printing press and spending it. Yet despite having this unique and extraordinary power, governments are reluctant to use it. Instead, they devolve the power of money creation to private banks. And here is how it works:

Imagine that you buy a Mother’s Day bunch of flowers on your credit card. What actually happens? Your bank credits the seller’s bank account, and debits your credit card account. No cash is involved. But money is somehow created. Otherwise, how would you be able to buy the flowers? The florist has the money, and you have a debt, on which you have to pay interest. And the funny thing is that the bank just made that money up out of the thinnest of thin air. The only place it came from was your promise to pay it back at a later date, plus interest. And this is what banks do – conjure up a credit in one place, and a debit in another. And make a profit by charging interest on it.

This illustrates a unique quality of bank-created money: someone has to pay interest on it – in this case, you. It’s the same story when a government borrows money to finance its spending: it has to pay the banks interest on something it actually has the power to create, for free. Now why should it want to do that?

Part of the answer lies deep in history. Paper money has its origins in the transferable receipts issued by medieval and renaissance goldsmiths for the deposit of physical gold – so much easier and safer to use such a receipt to buy, say, a merchant ship, than to hand over gold coins. Over time the goldsmiths morphed into banks, and of course they had to hold gold reflecting the value of the receipts they had issued. Not that they needed to back 100% of the receipts with gold, as all the depositors were never going to come at once and demand their gold back – or so they hoped.

So the goldsmiths would hold a proportion of their gold in their vaults, and lend out the remainder at interest – though their loans would often take the form of additional receipts. Intriguingly, this meant that more gold would be circulating in the form of receipts for gold than there was actual gold – but the goldsmiths, or bankers, would be careful to limit the credit they extended to some precise multiple of the amount of gold they held. This illustrates the principles of both fractional reserve banking (where only a fraction of customers’ deposits are held as gold or cash) and the gold standard.

Under a gold standard, paper money issued by central banks can be exchanged for gold on demand. However, it has an important downside: the volume of paper money in circulation is limited to some multiple of the amount of physical gold in the vaults. So governments operating gold standard currencies cannot just create money at will, according to either their need to spend, or the need of the economy for cash. This leaves the option of taxation – necessary but often insufficient – and borrowing. And that means borrowing back, at interest, the very money that they had issued in the first place, together with credit advanced to them by the private banks.

With the abolition of the gold standard (in 1931 in the UK, and 1971 in the US), central banks and governments were liberated from the restrictions it had imposed. Their money became fiat currencies – that is, money that is not backed by gold, silver or any other physical asset, but whose value is created exclusively by its role in the national economy as legal tender for the settlement of all debts, including those due to government as tax.

However, treasury ministers and central bankers remained supremely cautious about using the freedoms so acquired – in particular the freedom to issue their own money with no need to pay interest on it. Instead they stuck rigidly to the gold standard rules that had always applied, and had served them so well. So well? So well that they are the principal cause of successive recessions and depressions, including the one in which we now find ourselves.

But first let’s look more closely at the role of banks – and just why it is that governments should take back their rightful role as the prime creators of money. Although the central bank does indeed print the currency, far more money is conjured up by banks as they advance credit – on credit cards, mortgages and loans – than is ever printed (in the UK, about 40 times more). So the supply of money in the economy is mainly determined by the banks’ willingness, or otherwise, to advance that credit.

On the face of it the banks’ business is hard to beat – they conjure up money from nowhere, then charge interest on it. The problem arises if the debtor doesn’t pay the money back. Then the debt, which the bank had counted as an asset on its balance sheet, becomes worthless, while the creditor (the florist in the initial example) can still take his money out as cash. Of course banks are constantly having to write off bad debts, and in normal times the write-offs are more than paid for by the interest they receive. But if too many bad debts arise all of a sudden, a bank’s liabilities can exceed its assets, and it goes bust. We saw it happen to Northern Rock, Lehman Brothers and many others in the 2008/2009 crash.

In good times there is little perception of risk, so banks fall over themselves to advance credit – thus increasing the amount of money in circulation and further fuelling the boom. In bad times the reverse happens. Banks become very choosy about whom they advance credit to, and claw credit back from existing lenders at the slightest hint of trouble – often bankrupting perfectly viable businesses and putting numerous people out of work. And of course the economy as a whole suffers. So the behaviour of banks not only reflects but hugely magnifies the economy’s performance.

And in fact boom and bust is the inevitable consequence of bank-created money. Imagine that banks advance £100 billion of credit in one year, due for repayment the next with a 5% interest rate. Where exactly is the extra £5 billion to come from? With bank-created money, the only place it can come from is the banks themselves, advancing even more credit. So long as the economy is doing well, this process continues, with banks collectively advancing additional credit each year that can be used to pay the interest due on accumulated debts. But if, or rather when the economy for whatever reason – say a massive oil price hike – hits the rocks and people are short of money to pay their debts, banks take fright and contract their lending. So the money with which people would normally be able pay off their debts and interest simply is not there. The inevitable result is that businesses (including the banks themselves) fail, people go bankrupt and the economy tanks.

Now consider: the banks, whose reckless lending during the boom years of the early and mid-noughties created losses worth trillions of dollars, pounds or euros, were baled out one way or another by taxpayers. Governments borrowed this money, ultimately from the banks themselves, only to be told by the banks (wearing their ‘bond market’ hat) that social welfare, health and education and all other areas of public spending were now unaffordable luxuries that had to be drastically pruned back.

And learn the lesson of the Libor scandal – in which major banks manipulated the interest rates on inter-bank lending so as to win bets they had themselves placed on the movement of those interest rates. Banks have extraordinary powers to determine the course of entire economies through the granting or withholding of credit – and how are we to know that they are not abusing this power for their own gain? Certainly the banks are not restrained from such activities by any advanced sense of moral rectitude.

The obvious conclusion is that governments should assume the primary power both to create money and to manage its supply. Just as “war is too important a matter to be left to the military” (Georges Clemenceau), so the supply of money is far too important a matter to be left to the banks. Especially badly-behaved banks – but even the behaviour of well-behaved banks must give rise to the same fundamental economic instabilities.

This means two things: first, much tighter government control over banks to restrain the over-exuberant growth of credit, for example in the housing market, where the effect is to create unsustainable and inflationary asset price booms. Second, a willingness by governments to issue new, debt-free money – money on which no interest needs to be paid – according to the demands of the economy. This does not put an end to taxation and borrowing: on the contrary, both remain as necessary tools of macroeconomic management. It just adds a vital new policy dimension.

So in a recession or a depression like the current one, governments should be totally unashamed about issuing and spending new money. If the banks are not creating the money that the economy needs (but are actually contracting the money supply), then it’s a role that only the government and its central bank can play. This is not inflationary – because in a recession, by definition, economic resources (like factories and workers) are idle or under-utilised. The effect of the spending is to mobilise those idle resources back into production – for example, building housing, schools, hospitals, railway lines, art galleries, sports facilities and other long-lived public assets.

And there is no need for the government to borrow the money. Its job is rather to create the money the economy needs, to make good the shortfall resulting from the banks’ contraction of credit. Note that the spending of debt-free public money by governments is not the same as quantitative easing (QE) as carried out by the Bank of England and other central banks, which is the issue of new money to buy government bond - in the apparent hope that the banks will use it to lend to struggling businesses and homebuyers. However, banks prefer to simply add the cheap money from QE to their reserves (meaning that they are willing to pay only derisory interest to savers) or to lend it to the very people and companies that need it least. Result: no measurable economic benefit, except to the banks themselves. Logic also dictates that governments should undertake major programmes of public investment precisely when the economy is weak, because when the private economic sector is powering ahead, finite economic resources are already highly mobilised and there is little spare capacity. The extra demand created by strong public spending in boom times is inflationary (by increasing competition for scarce resources) and requires increased imports of both goods and labour.

For example, if the private sector is building homes hand over fist, it’s clearly not the right time to embark on a massive programme of public housing, as all the bricklayers, plasterers, plumbers, electricians and roofers are already busy. The time for that is when the workers are unemployed, and building materials suppliers are short of buyers.

So recessions, far from being periods of unremitting economic gloom, are actually a unique time of opportunity for governments to invest in public assets, in the process creating millions of desperately needed jobs and increasing prosperity and wellbeing for decades into the future.

A particular present need is to effect a rapid transition to an economy that no longer depends on fossil fuels. Not only is their supply unsustainable beyond the short term (oil) to medium term (gas and coal), but also pollution from fossil fuels threatens global climatic stability and is a major cause of ill health around the world. There can be few better investments in our future quality of life than in renewable energy generation, the wider energy infrastructure needed to support it, and in improving energy efficiency.

But those managing recession-hit Western economies are squandering that opportunity, and instead seizing another: the opportunity to attack ordinary people’s living standards and the provision of public goods like housing, health and education. One might reasonably ask why.

It may be the simple result of economic ignorance, although there is scant excuse for it. The fundamental tenets of modern monetary theory (MMT) – the theory of how to manage economies using fiat as opposed to asset-backed currencies – were first set out in 1895 by the German economist Georg Knapp, and his key work The State Theory of Money was translated into English in 1924. MMT continues to arouse plenty of debate, but its core propositions, which include the arguments set out here, are incontrovertible. There is certainly no justification for adhering to the obsolete macroeconomics of George Osborne and his fellows: they are not only manifestly wrong from a theoretical perspective, but are demonstrated to be so through their utter failure in practice.

So are there other, perhaps darker reasons for the insistence of those in power over us on endless austerity and budget cutbacks? Consider the huge political and economic power of the banks. Their monopoly privilege of creating money, and the power so conferred, is not one they will give up lightly. Those who control the economy, through both their own wealth and their control of the banking system, wish to retain that control for their own ends – not to dilute it or cede even part of to democratic institutions. Moreover, the creation of poverty and scarcity has the effect of boosting the power, privilege and exclusivity of the super-rich – not so much the 1%, but the 1% of the 1%. And it is they – apparently no matter of what political hue the government of the day may be – who ultimately seem to call the shots. While the rest of us pay the price.

In the end, it comes down to two simple truths. First, the rich and powerful may own most of the money, but this gives them no right to own the money system itself. The money system is a public good, or commons, in which all of us have an equal stake. Second, the entire political class (and the economic elite that it serves) holds that people, and indeed the entire world and its resources, exist to serve the economy and comply with its dictates.

But this is the very reverse of the truth. Money is a product of the collective human imagination – and if it serves us badly, we can and should change the way it works. And as Gaylord Nelson put it, “The economy is a wholly owned subsidiary of the environment, not the other way round.” It is high time for us, the people, to assume the ownership and control of the money system that is rightly ours – and to use that power to generate wealth, freedom and security for us all. And to protect, not destroy, the wonderful planet that is our only home.